Saturday, November 1, 2008

The Warren Buffett Way: Chp 3 Part 1: Mr. Market and the Lemmings

Benjamin Graham taught us that one difference between investors and speculators is in their attitudes in buying stocks (or bonds). Speculators try to anticipate and profit from price changes and investors simply try to acquire companies at reasonable prices. He introduced the fictional character Mr. Market, who we can think as someone who will always offer us a buy and sell price for every stock any day the market is open. It's up to us to determine what a rational price is for a stock. The concept of Mr. Market is important for investors in order to keep in mind that stock prices could be ridiculously high, low or reasonable on any given day. He teaches that Mr. Market is here to serve us, not to advise us.

Warren Buffett believes that in the long term, stock prices track very strongly to the economic progress of the underlying company. He realizes that the stock market could undervalue or overvalue a stock on any given day and for that reason he doesn't put any credence into short term stock market predictions. He has said that stock market forecasters make fortune tellers look good!

Buffett believes that investors need to master their emotions and be prepared psychologically to stomach the volatility of stock markets or they shouldn't invest in stocks. According to Buffett, pessimism in the market is a good but not sufficient sign to invest in stocks. He likes to do business in a pessimistic market because he likes the prices it produces.

Investors dislike owning stocks when prices are down but Buffett sees it as a potential buying opportunity. Buffett has said that he "tries to by fearful when others are greedy and greedy when others are fearful". He opines that "the future is never clear but you pay a very high price for a cheery consensus". Pessimism in the marketplace is not enough to warrant the purchase of stocks, Buffett has said that to earn superior profits, an investor needs to carefully calculate the economic value of a business.

Buffett feels that individual investors have an advantage in the marketplace as long as they can take advantage of the illogical behaviour of larger institutions. To do so, investors need to stick to business fundamentals and ignore what the market is doing. Buffett has said that for him, the stock market doesn't exist, its only there to see if someone is doing something foolish.